Know Your Annuity Options!

There is a great deal of "noise" around the country about the advantages of owning an annuity with life contingencies. Even the federal government seems to have finally recognized that income that cannot be outlived is superior to income that is only designed to be for "life expectancy." The current instability of the Social Security system, combined with increasing life expectancy is causing more and more people who are at or approaching retirement to consider a life contingency annuity as an important part of their retirement planning. A life contingency annuity is, in effect, insurance against living too long. The huge wave of approaching "baby-boomer" retirements is bound to create a greater emphasis on retirement income that cannot be outlived.

Assuming that more and more people will choose some form of a life contingency annuity for their retirement portfolios, the question arises: what form of retirement income option should be selected?

The original form of an annuity, the straight life annuity, is perhaps the oldest form of life insurance (we sometimes encounter confusion when we refer to annuities as a form of "life insurance," but it really is "life" insurance as opposed to the "death" insurance we generally think of as "life insurance"). Prior to the advent of commercial life insurers during the industrial revolution, most life annuities were private affairs between individuals--usually individuals with a family relationship. These private annuities were often used for dowager wives of wealthy families or for illegitimate or prodigal children. Today, private annuities are very much in use for family situations to provide retirement income for someone whose main assets are otherwise illiquid, such as for the sale of a closely held business.

A straight life annuity is a promise to pay a stated or determinable sum for the life of the recipient. Payments stop at the death of the annuitant. Commercial life insurers have never had much success getting their policyholders to opt for straight life annuities. Annuity owners want to "hedge" against premature death. They are atavistically opposed to the thought of the insurer having a windfall profit in the event the annuitant dies early in the annuity payment period. As a result, insurers have developed a wide variety of annuity options--all of which provide some type of hedge against loss of the annuity's principal in the event of death early in the annuity payment period. Indeed, most annuity policies, whether fixed or variable, provide for three or four standard annuity options that can be elected but then provide that the insurer will provide any other type of option that is jointly agreeable to the insurer and the annuitant.

Annuities that provide a "hedge" against the early death of the annuitant are often referred to as "life contingency with a refund annuity." The most common form is an annuity that promises to pay specified or determinable payments for life, but with the provision that if the annuitant dies before payments have been made for some specified time (the standard policy option provides for a ten year "certain" period, but other durations are usually available), then payments will continue to be made to the beneficiaries under the annuity for the remainder of the specified time. Refund annuities are often called "life and term certain annuities." Most purchasers of annuities feel more comfortable with a life and term certain option than with a straight life annuity. The catch to this type of product is that the life and term certain annuity pays smaller annuity payments than is the case with the straight life annuity. This is because the actuaries designing the payment tables must provide for funding of the term certain and the only way to do this is by reduced annuity payments. The difference between the payments under a straight life annuity and a life and term certain annuity can be substantial. The difference in the amount of payment, in effect, pays the insurer for the mortality risk inherent in promising to make payments for a specified period of time.

Retirees who need to maximize retirement income should consider whether life and term certain annuities are worth the additional cost inherent in reduced annuity payments. Although it is certainly understandable that people want to leave something to their children or the other natural objects of their bounty, it should not be at the risk of having too little retirement income to provide basic comfort.

Most purchasers of annuities are concerned about outliving their retirement funds not only for themselves, but also for their spouses. Thus, most annuity policies provide an option to take annuity payments for the joint lives of two or more people. Moreover, these joint life options can also provide for term certain features. The amount of annuity payments will reflect the melded ages of the annuitants, often causing a reduction in annuity payments where there is a great disparity in the ages of the joint annuitants.

Over the past few decades insurers have developed a variety of additional annuity options, all of which generally provide for refund of some portion of the annuity's principal in the event of the premature death of the annuitant or annuitants. Many variable annuities and some index annuities provide ancillary features to guarantee the amount and duration of annuity payments.

It should be obvious that planning for annuity options as retirement approaches is as important as estate planning. Determining financial needs, life expectancy and contingency options requiring liquidity are essential elements in retirement planning and require professional assistance if retirees are to be properly prepared to enjoy their golden years. Fortunately, there exist numerous useful software programs that will assist financial professionals to counsel their clients. We strongly recommend early review of retirement needs and that retirees who own annuities never settle for a mere "boilerplate" annuity option unless it has been determined that that is the best option available for their needs.